The Next Big E-Commerce Wave: Vertically Integrated Commerce

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Editor’s note: Boris Wertz is the founder of version one ventures, and has invested in more than 35 early-stage consumer Internet and mobile companies, including Chloe & Isabel, Julep, and Indochino. Follow him on his blog and Twitter.

There has been more e-commerce innovation during the past year than there has been during the last decade.

First, flash-sale and daily-deal sites brought a much-needed breath of fresh air to a vertical that hadn’t seen much change since Amazon and eBay arrived on the scene. Now there’s a whole new generation of e-commerce players. Ever heard of Nasty Gal, Warby Parker, Indochino, Stella Dot, Chloe & Isabel, Frank & Oak, Julep, Beachmint, Shoedazzle, ModCloth, Everlane, Bonobos or J Hilburn? Together, this group of companies will generate over a billion dollars in revenue in 2012.

These web-only brands are vertically integrating the retail value chain, including manufacturing, branding, and distribution. By eliminating stores from the supply chain, these companies bring products directly to consumers from the factory without the bloat of the traditional retailer. This translates into high-quality products (whether eyeglasses or t-shirts) at significantly lower prices.

Here are three reasons why vertically integrated commerce is an attractive retail model.

1. Unique product lines mean no competing with Amazon

Any brick and mortar retailer will attest that it’s pretty difficult to compete with Amazon on price. In the aisles of any shop, a lower price is just a click away. The situation isn’t any easier for online retailers either. E-commerce giants are nearly unbeatable on price. Chris Dixon quoted one entrepreneur as saying, “If it has a UPC code, Amazon will beat you.” Vertically integrated retailers don’t have to compete head-to-head with Amazon. By making their own unique products that can’t be found elsewhere through a quick Google search, these pure play e-tailers can still thrive — even surrounded by large incumbents.

2. Unique products lay the foundation to a unique brand

Warby Parker has its own brand. As does the Dollar Shave Club and Bonobos. A key benefit of being an online niche retailer is the ability to build a distinct, easily recognizable brand that can grow customer loyalty even as new brands are just a click (or discovery site) away. While physical stores may have once enjoyed the advantage in crafting cool shopping experiences, the aesthetics of the iPad and all the social sharing surrounding online shopping today are now shifting that advantage to online retailers.

3. Less bloat = better prices and margins

The traditional retail value chain has significant costs built into both the retail and wholesale channel – such as stores, warehouses, and inventory. By controlling the whole supply chain, vertically integrated companies take a lot of the costs out of the system. That can be good news for consumers: They get high-quality products at a fraction of the price at department stores and other retailers. Hil Davis, co-founder and chief executive officer of J. Hilburn tells Businessweek that a typical garment from most retailers is marked up three times as it works its way through the supply chain from the factory to the store. According to Davis, a men’s dress shirt costs J. Hilburn approximately $57 to manufacture. They sell this shirt directly to consumers for $125, while another brand’s shirt sourced from the very same Italian mill can cost upwards of $325-$435 at Neiman Marcus.

The challenges facing vertically integrated retailers

For every online retailer success story like Bonobos or J. Hilburn, there are countless other e-tailers struggling to make their way. Vertically integrated companies are hard to start and hard to scale.

For starters, product design is tougher than merchandising, so a startup team needs to have someone experienced in the space who really connects with the target audience. Then, there are supply chain complexities: Vertically integrated retailers need to build a strong network of manufacturing partners and effectively manage these partners.

In addition, retailers generally need to order minimum quantity from manufacturers, so there is significant inventory risk if products cannot be sold. Vertically integrated commerce only works profitably at large scale, meaning that funding requirements are relatively high.

However, the downside also offers an upside. All these challenges create a significant barrier to entry; this means that once a vertically integrated company makes it, they’re less likely to be uprooted by the latest up-and-comer.

The beginning of the wave

We’re just seeing the start of innovation and investment activity when it comes to vertically integrated commerce. Today this direct-to-consumer model has begun to disrupt the apparel and jewelry verticals, but expect to see more online-only brands emerge in other markets over the coming years. From furniture to beauty products, most commerce is ripe for disruption. Consumers are ready for high-quality, unique products, and lower costs and the opportunities are just beginning.